Liquidity Crunch Redux
December 2nd, 2014 8:10 pmThe Dodd Frank bill created something called the Office of Financial Research which is tucked away somewhere in the Department of the Treasury. The rocket scientists toiling away at that bureaucratic hideaway have reached the conclusion that we should prepare for more days like October 15 2014 when the Great Short Squeeze forced the yield on the 10 year note down to 1.85 percent. On that day more securities were demanded that the dealers could provide at prices close to prevailing levels.
I think the bigger risk is when the bell tolls on the multi year bull market in bonds and investors seek to escape the corporate bond market. The Fed owns giant chunks of Treasuries and MBS and will not be selling those assets. However, the gargantuan appetite for yield created by the years of zero rates has left real retail as holders of inordinate amount of corporates some of which are extremely illiquid. Deals like the mega Verizon deal of several years ago or yesterday’s Medtronic deal will not be immune but will fare better than the offspring of some $250 million first mortgage bond issued as a 30 year which is now (hypothetically) a 27 year bond. The small insurance company trying to sell its $1.75 million of that detritus should prepare for an ugly bid or a dealer request for a risk free order.
The bottom line is that when the bell some day finally tolls the end of the secular bull market in bonds there will be far more bonds for sale than dealers can purchase under the current regulatory regime.
Via the WSJ:
U.S. Watchdog Sees Risk of Repeated Liquidity Crunches
Office of Financial Research Cites Less Liquidity as One Increasing Risk to U.S. Financial System
WASHINGTON—The U.S. financial system is growing more vulnerable to debilitating shocks as new regulations and market forces change trading habits and reduce the willingness of some market participants to smooth out volatility, a government watchdog warned.
The Office of Financial Research, a new arm of the Treasury Department created by the 2010 Dodd-Frank law, said the system is vulnerable to repeats of what occurred in October, when tumult in the trading of U.S. Treasury securities spread broadly to futures, swaps and options markets.
“Although the dislocation that peaked in mid-October was fleeting, we believe there is a risk of a repeat occurrence,” the office said in its third annual report, adding that such volatility “raises a host of financial stability concerns.”
The report highlights concerns that have been simmering for more than a year related to a decline in liquidity, or the ability of market participants to buy or sell securities quickly at a given price. The worry is that without enough liquidity, price swings could become more severe across financial markets, raising the cost of credit on Wall Street and Main Street. The report said such swings could be exacerbated by computerized trading and algorithms, as high volumes of transactions automatically execute, deepening instability.
The decline in liquidity is attributed to several factors, including less willingness by large banks to facilitate trading as new regulations make lending cash and securities more expensive. Regulators have said the rules are necessary and will reduce the kinds of excess borrowing that fueled the 2008 financial crisis.
A reduction in securities that are available to lend against in financial markets—such as Treasury bonds and asset-backed securities—is also fueling the volatility. The securitization markets have shrunk since the financial crisis and the Federal Reserve has further reduced the amount of available securities by snapping up trillions of dollars in bonds in recent years.
While the report cites the potential for financial instability, it said the financial system is overall better off than it was six years ago. “Compared with the period just before the financial crisis, threats to financial stability are moderate,” Office of Financial Research Director Richard Berner wrote in a letter that accompanied the report. “But that relatively benign backdrop is no cause for complacency.”
The findings could prompt regulators to take a closer look at the impact of their rules and could give ammunition to critics who say Washington has gone too far in its efforts to suck risk out of banks.
The report identified several other risks, including a “rapid expansion in corporate credit” that is being extended, increasingly, by nonbank entities outside regulators reach.